J R Varma Group

This one is not written up yet

The definition above is the short version. A full explanation — how it works, a worked example and the exam traps — is still being written. In the meantime the chapter below covers it in context.

Written up from the same chapter

• DerivativeA contract whose value is derived from the value of something else — the underlying — rather than from anything the contract itself owns or produces.
• Exchange traded derivativeA derivative traded on an organised exchange on standardised terms, with prices set by anonymous auction and performance guaranteed by a clearing corporation — as against a bilateral, customised OTC contract.
• HedgerA participant who already carries interest rate risk from a real business exposure and uses derivatives to remove it, rather than to take a view on the market.
• Liquidity riskThe risk of being unable to get out of a position at or near the quoted price — because the contract is bilateral, because the order book is thin, or because volumes dry up near expiry.
• OptionA contract giving the buyer the right, but not the obligation, to buy or sell the underlying at a stated price on or before a stated date, in exchange for a premium paid to the writer.
• Price discoveryThe process by which the free interaction of buyers and sellers produces a price that reflects every participant's expectation of what the underlying will be worth at a future date.